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Chapter 9 Why Does a Company Need a Cost Flow Assumption in Reporting Inventory? Video Clip (click to see video) Joe introduces Chapter 9 "Why Does a Company Need a Cost Flow Assumption in Reporting Inventory?" and speaks about the course in general. 302 Chapter 9 Why Does a Company Need a Cost Flow Assumption in Reporting Inventory? 9.1 The Necessity of Adopting a Cost Flow Assumption LEARNING OBJECTIVES At the end of this section, students should be able to meet the following objectives: 1. Understand the reason that accounting rules are often standardized so that all companies report many events in the same manner. 2. Know that the selection of a particular cost flow assumption is necessary when inventory is sold. 3. Apply the following cost flow assumptions to determine reported balances for ending inventory and cost of goods sold: specific identification, FIFO, LIFO, and averaging. Question: In the coverage of financial accounting to this point, general standardization has been evident. Most transactions are recorded in an identical fashion by all companies. This defined structure helps ensure understanding. It also enhances the ability of decision makers to compare results from one year to the next or from one company to another. For example, inventory—except in unusual circumstances—is always reported at historical cost unless its value is lower. Experienced decision makers should be well aware of that criterion when they are reviewing the inventory figures reported by a company. However, an examination of the notes to financial statements for some well-known businesses shows an interesting inconsistency in the reporting of inventory (emphasis added). Mitsui & Co. (U.S.A.) Inc.—as of March 31, 2009: “Inventories, consisting mainly of commodities and materials for resale, are stated at the lower of cost, principally on the specific-identification basis, or market.” Johnson & Johnson and Subsidiaries—as of December 28, 2008: “Inventories are stated at the lower-of-cost-or-market determined by the first-in, first-out method.” Safeway Inc. and Subsidiaries—as of December 31, 2008: “Merchandise inventory of $1,740 million at year-end 2008 and $1,866 million at year-end 2007 is valued at the lower of cost on a last-in, first-out (‘LIFO’) basis or market value.” 303 Chapter 9 Why Does a Company Need a Cost Flow Assumption in Reporting Inventory? Bristol-Myers Squibb—as of December 31, 2008: “Inventories are generally stated at average cost, not in excess of market.” “Specific-identification basis,” “first-in, first-out,” “last-in, first-out,” “average cost”—what information do these terms provide? Why are all of these companies using different methods? In the financial reporting of inventory, what is the significance of disclosing that a company applies “first-in, first-out,” “last-in, first-out,” or the like? Answer: In the previous chapter, the cost of all inventory items was kept constant over time. Although that helped simplify the initial presentation of relevant accounting issues, such stability is hardly a realistic assumption. For example, the retail price of gasoline has moved up and down like a yo-yo in recent years. The cost of some commodities, such as bread and soft drinks, has increased gradually for many decades. In other industries, prices actually tend to fall over time. New technology products often start with a high price that drops as the manufacturing process ramps up and becomes more efficient. Several years ago, personal computers cost tens of thousands of dollars and now sell for hundreds. A key event in accounting for inventory is the transfer of cost from the inventory Taccount to cost of goods sold as the result of a sale. The inventory balance is reduced and the related expense is increased. For large organizations, such transactions can take place thousands of times each day. If each item has an identical cost, no problem exists. This standard amount is always reclassified into expense to reflect the sale. However, if inventory items are acquired at different costs, which cost is moved from asset to expense? At that point, a cost flow assumption must be selected by company officials to guide reporting. That choice can have a significant impact on both the income statement and the balance sheet. It is literally impossible to analyze the reported net income and inventory balance of a company such as ExxonMobil without knowing the cost flow assumption that has been applied. Question: An example is probably the easiest approach by which to demonstrate cost flow assumptions. Assume a men’s retail clothing store holds $120 in cash. On October 26, Year One, one blue dress shirt is bought for $50 in cash for resell purposes. Later, near the end of the year, this style of shirt becomes especially popular. On December 29, Year One, the store’s manager buys a second shirt exactly like the first but this time at a cost of $70. Cash on hand 9.1 The Necessity of Adopting a Cost Flow Assumption 304 Chapter 9 Why Does a Company Need a Cost Flow Assumption in Reporting Inventory? has been depleted completely ($120 less $50 and $70) but the company now holds two shirts in its inventory. Then, on December 31, Year One, a customer buys one of these two shirts by paying cash of $110. Regardless of the cost flow assumption, the company retains one blue dress shirt in inventory at the end of the year and cash of $110. It also reports sales revenue of $110. Those facts are not in doubt. From an accounting perspective, two questions are left to be resolved (1) what is the cost of goods sold reported for the one shirt that was sold and (2) what is the cost remaining in inventory for the one item still on hand? In simpler terms, should the $50 or $70 be reclassified to cost of goods sold; should the $50 or $70 remain in ending inventory? For financial accounting, the importance of the answers to those questions cannot be overemphasized. What are the various cost flow assumptions and how are they applied to inventory? Answer: SPECIFIC IDENTIFICATION. In a literal sense, specific identification1 is not a cost flow assumption. Companies that use this approach are not making an assumption because they know which item was sold. By some technique, they are able to identify the inventory conveyed to the customer and reclassify its cost to expense. For some types of inventory, such as automobiles held by a car dealer, specific identification is relatively easy to apply. Each vehicle tends to be somewhat unique and can be tracked through identification numbers. Unfortunately, for many other types of inventory, no practical method exists for determining the physical flow of merchandise. Thus, if the men’s retail store maintains a system where the individual shirts are marked in some way, it will be possible to know whether the $50 shirt or the $70 shirt was actually conveyed to the customer. That cost can be moved from asset to expense. 1. Inventory cost flow method in which a company physically identifies both its remaining inventory and the inventory that was sold to customers. However, for identical items like shirts, cans of tuna fish, bags of coffee beans, hammers, packs of notebook paper and the like, the idea of maintaining such precise records is ludicrous. What informational benefit could be gained by knowing whether the first blue shirt was sold or the second? In most cases, the cost 9.1 The Necessity of Adopting a Cost Flow Assumption 305 Chapter 9 Why Does a Company Need a Cost Flow Assumption in Reporting Inventory? of creating such a meticulous record-keeping system far outweighs any potential advantages. FIRST-IN, FIRST-OUT (FIFO). The FIFO2 cost flow assumption is based on the premise that selling the oldest item first is most likely to mirror reality. Stores do not want inventory to grow unnecessarily old and lose freshness. The oldest items are often placed on top in hopes that they will sell first before becoming stale or damaged. Therefore, although the identity of the actual item sold is rarely known, the assumption is made in applying FIFO that the first (or oldest) cost is always moved from inventory to cost of goods sold. Note that it is not the oldest item that is necessarily sold but rather the oldest cost that is reclassified to cost of goods sold. No attempt is made to determine which shirt was purchased by the customer. Here, because the first shirt cost $50, the following entry is made to record the expense and reduce the inventory. Figure 9.1 Journal Entry—Reclassification of the Cost of One Piece of Inventory Using FIFO For this retail store, the following financial information is reported if FIFO is applied. Two shirts were bought for ($50 and $70) and one shirt was sold for $110. FIFO Cost of Goods Sold (One Unit—the First One) $50 2. Inventory cost flow assumption based on the oldest costs being transferred first from inventory to cost of goods sold so that the most recent costs remain in ending inventory. Gross Profit ($110 less $50) $60 Ending Inventory (One Unit—the Last One) $70 In a period of rising prices, the earliest (cheapest) cost moves to cost of goods sold and the latest (more expensive) cost is retained in ending inventory. For this reason, in inflationary times, FIFO is associated with a higher reported net income as well as a higher reported inventory total on the company’s balance sheet. Not surprisingly, these characteristics help make it a popular choice. 9.1 The Necessity of Adopting a Cost Flow Assumption 306 Chapter 9 Why Does a Company Need a Cost Flow Assumption in Reporting Inventory? EXERCISE Link to multiple-choice question for practice purposes: http://www.quia.com/quiz/2092903.html LAST-IN, FIRST-OUT (LIFO). LIFO3 is the opposite of FIFO: the most recent costs are moved to expense as sales are made. Theoretically, the LIFO assumption is often justified as more in line with the matching principle. Shirt One was bought on October 26 whereas Shirt Two was not acquired until December 29. Revenue was earned on December 31. Proponents of LIFO argue that matching the December 29 cost with the December 31 revenue is more appropriate than using a cost incurred months earlier. According to this reasoning, income is more properly determined with LIFO because a relatively current cost is shown as cost of goods sold rather than a figure that is out-of-date. The difference is especially apparent in periods of high inflation. “By matching current costs against current sales, LIFO produces a truer picture of income; that is, the quality of income produced by the use of LIFO is higher because it more nearly approximates disposable income.”Clayton T. Rumble, “So You Still Have Not Adopted LIFO,” Management Accountant, October 1983, 50. Note 1 to the 2008 financial statements for ConocoPhillips reiterates that point: “LIFO is used to better match current inventory costs with current revenues.” The last cost incurred in buying two blue shirts was $70 so that amount is reclassified to expense at the time of the first sale. Figure 9.2 Journal Entry—Reclassification of the Cost of One Piece of Inventory Using LIFO 3. Inventory cost flow assumption based on the most recent costs being transferred first from inventory to cost of goods sold so that the oldest costs remain in ending inventory. Although the physical results of these transaction are the same (one unit was sold, one unit was retained, and the company holds $110 in cash), the financial picture painted using the LIFO cost flow assumption is quite different from in the earlier FIFO example. LIFO Cost of Goods Sold (One Unit—the Last One) $70 9.1 The Necessity of Adopting a Cost Flow Assumption 307 Chapter 9 Why Does a Company Need a Cost Flow Assumption in Reporting Inventory? LIFO Gross Profit ($110 Less $70) $40 Ending Inventory (One Unit—the First One) $50 Characteristics commonly associated with LIFO can be seen in this example. When prices rise, LIFO companies report lower net income (the most recent and, thus, the most costly purchases are moved to expense) and a lower inventory account on the balance sheet (because the earlier and cheaper costs remain in the inventory Taccount). As will be discussed in a subsequent section, LIFO is popular in the United States because it helps reduce the amount companies pay in income taxes. EXERCISE Link to multiple-choice question for practice purposes: http://www.quia.com/quiz/2092888.html Averaging4. Because the identity of the items conveyed to buyers is unknown, this final cost flow assumption holds that using an average of all costs is the most logical solution. Why choose any individual cost if no evidence exists of its validity? The first item received might have been sold or the last. Selecting either is an arbitrary decision. If items with varying costs are held, using an average provides a very appealing logic. In the shirt example, the two units cost a total of $120 ($50 plus $70) so the average is $60 ($120/2 units). Figure 9.3 Journal Entry—Reclassification of the Cost of One Piece of Inventory Using Averaging Although no shirt did cost $60, this average serves as the basis for both cost of goods sold as well as the cost of the item still on hand. All costs are included in arriving at each reported figure. 4. Inventory cost flow assumption based on the average cost being transferred from inventory to cost of goods sold so that the same average cost remains in ending inventory. Averaging Cost of Goods Sold (One Unit—the Average One) $60 Gross Profit ($110 less $60) 9.1 The Necessity of Adopting a Cost Flow Assumption $50 308 Chapter 9 Why Does a Company Need a Cost Flow Assumption in Reporting Inventory? Averaging Ending Inventory (One Unit—the Average One) $60 Averaging has many supporters. However, it can be a more complicated system to implement especially if costs change frequently. In addition, it does not offer the benefits that make FIFO (higher reported income) and LIFO (lower taxes in the United States) so appealing. Company officials often arrive at such practical decisions based on an evaluation of advantages and disadvantages and not on theoretical merit. EXERCISE Link to multiple-choice question for practice purposes: http://www.quia.com/quiz/2092923.html KEY TAKEAWAYS U.S. GAAP tends to apply standard reporting rules for many transactions to make financial statements more usable by decision makers. The application of an inventory cost flow assumption is one area where a significant variation is present. A company can choose to use specific identification, first-in, first-out (FIFO), last-in, first-out (LIFO), or averaging. Each of these assumptions determines the cost moved from inventory to cost of goods sold to reflect the sale of merchandise in a different manner. The reported inventory balance as well as the expense on the income statement (and, hence, net income) are dependent on the cost flow assumption that is selected. 9.1 The Necessity of Adopting a Cost Flow Assumption 309 Chapter 9 Why Does a Company Need a Cost Flow Assumption in Reporting Inventory? 9.2 The Selection of a Cost Flow Assumption for Reporting Purposes LEARNING OBJECTIVES At the end of this section, students should be able to meet the following objectives: 1. Appreciate that reported inventory and cost of goods sold numbers are not intended to be right or wrong but rather must conform to U.S. GAAP, which includes several different allowable cost flow assumptions. 2. Recognize that three cost flow assumptions (FIFO, LIFO, and averaging) are particularly popular in the United States. 3. Understand the meaning of the LIFO conformity rule and realize that use of LIFO in the U.S. largely stems from the presence of this tax rule. 4. Know that U.S. companies prepare financial statements according to U.S. GAAP and their income tax returns based on the Internal Revenue Code so that significant differences often exist. Question: FIFO, LIFO, and averaging can present radically different portraits of identical events. Is the gross profit for this men’s clothing store really $60 (FIFO), $40 (LIFO), or $50 (averaging) in connection with the sale of one blue shirt? Analyzing the numbers presented by most companies can be difficult if not impossible without understanding the implications of the assumption applied. Which of the cost flow assumptions is viewed as most appropriate in producing fairly presented financial statements? Answer: Because specific identification reclassifies the cost of the actual unit that was sold, finding theoretical fault with that approach is difficult. Unfortunately, specific identification is nearly impossible to apply unless easily distinguishable differences exist between similar inventory items. That leaves FIFO, LIFO, and averaging. Arguments over both their merits and problems have raged for decades. Ultimately, the numbers in financial statements must be presented fairly based on the cost flow assumption that is applied. In Chapter 6 "Why Should Decision Makers Trust Financial Statements?", an important distinction was made. The report of the independent auditor never assures decision makers that financial statements are “presented fairly.” That is a hopelessly abstract concept like truth and beauty. Instead, the auditor states that 310 Chapter 9 Why Does a Company Need a Cost Flow Assumption in Reporting Inventory? the statements are “presented fairly…in conformity with accounting principles generally accepted in the United States of America.” That is a substantially more objective standard. Thus, for this men’s clothing store, all the following figures are presented fairly but only in conformity with the cost flow assumption used by the reporting company. Figure 9.4 Results of Possible Cost Flows Assumptions Used by Clothing Store Question: Since company officials are allowed to select a cost flow assumption, which of these methods is most typically found in the reporting of companies in the United States? Answer: To help interested parties gauge the usage of various accounting principles, a survey is carried out annually of the financial statements of six hundred large companies in this country. The resulting information allows accountants, auditors, and decision makers to weigh the validity of a particular method or presentation. For 2007, that survey found the following frequency of application of cost flow assumptions. Some companies use multiple assumptions: one for a particular part of inventory and a different one for the remainder. Thus, the total here is well above six hundred even though over one hundred of the surveyed companies did not have inventory or mention a cost flow assumption (inventory was probably an immaterial amount). As will be discussed a bit later in this chapter, using multiple assumptions is especially common when a U.S. company has subsidiaries located internationally. Inventory Cost Flow Assumptions—600 Companies SurveyedYury Iofe, senior editor, and Matthew C. Calderisi, CPA, managing editor, Accounting Trends & Techniques, 62nd edition (New York: American Institute of Certified Public Accountants, 2008), 159. First-in, First-out (FIFO) 9.2 The Selection of a Cost Flow Assumption for Reporting Purposes 391 311